Estimation of Stock’s Fair Value Price Range
In my stock analysis process, I attempt to estimate the fair value of a given stock. I estimate the fair value range (instead of a one fair value). This estimation should be interpreted as the price I am willing to pay based on my risk profile and my investing objective. My fair value estimation does not necessarily attempt to determine the fair value based on value investing principles.
My process of determining the fair value captures the essence of “what is being priced by the market” and “historically what has been priced by the market”.
(I) NPV price based on 15 year DCF: I have discussed DCF based net present value pricing.
(II) Average high yield price calculated based on past 10 years
I am attempting to estimate what would be current stock’s price based on its historical dividend payment standards. I measure this using yield. It is calculated as follows.
(i) For Year 1, I calculate the high yield in percentage.
[(Year 1 dividends) / (lowest stock price in Year 1)]
(ii) I continue to calculate this for Year 2, Year 3, and so on. Ideally, I would like to calculate this for at least past 10 years, but in many cases data is not easily available. I calculate for as many number of years as possible, and then make judgment call if it is worth digging more data.
(iii) I calculate average of ‘high yield’
[Year 1 high yield + Year 2 high yield + …..] / (number of years)]
This gives me 10 year average high yield.
(iv) I calculate the price based on this 10 year average high yield.
[(Current Dividends) / (10 year average high yield)]
(III) Pricing relative to 10 year average PE ratio
Here, I am attempting to estimate what would be current stock’s price based it’s historically market pricing.
(i) For Year 1, I calculate the average PE ratio.
[(Year 1 average stock price) / (adjusted EPS)]
(ii) I continue to calculate this for Year 2, Year 3, and so on. Ideally, I would like to calculate this for at least past 10 years, but in many cases data is not easily available. I calculate for as many number of years as possible, and then make judgment call if it is worth digging more data.
(iii) I calculate 10 year average PE ratio
[(Year 1 average PE + Year 2 average PE + …..) / (number of years)]
(iv) I calculate the relative price based on this 10 year average PE ratio.
[(Trailing Three Years Average EPS) x (10 year average PE ratio)]
(IV) Pricing based on PE ratio of 12
This is very simple straight forward calculation.
[(Trailing Three Years Average EPS) x (PE ratio of 12)]
(V) Graham number
Graham number is the formula Ben Graham used to calculate the “maximum” price one should pay for the stock. According this rule of thumb – the product of P/E ratio and price-to-book should not be more than 22.5 (P/E ratio of 15 x price-to-book value of 1.5). The 15 P/E came from the thought that Graham wanted his portfolio to have a yield that is equal yield to that of AA bond (during those days this yield being 7.5%). The inverse of this yield is 1 divided by 7.5%. This is approximately equal to 13.3, which Graham rounded up to 15. I calculate Graham number as follows:
Square Root [ (22.5) x (book value per share) x (EPS) ]
I have been investigating to use tangible book value in this formula. I may change this in future. But for now, I will continue to use book value. I have observed that it does not have any significant effect on my fair value range calculation.
Fair Value Range
At this point, I go on to calculate the fair value range.
High End = [ Average of above five criteria ]
Low End = [ (Average of above five criteria) – (0.5)x(Std Dev) ]
I hope this helps understand how I estimate fair value for my stock investments.
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Estimation, Fair Value Range
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